A Reddit army descends on hedge funds chained by risk models

Photographer: Tiffany Hagler-Geard / Bloomberg

A hellish week for hedge funds will be remembered for how much damage done by Reddit merchants by chasing a handful of the most shorted names in the $ 43 trillion US stock market.

But why were the institutional professionals forced to do so reduce their market risks at the fastest pace since the pandemic-induced route in March?

One reason is that their risk models said so.

When a stream of retail money shares like GameStop Corp. and AMC Entertainment Holdings Inc. soaring, the trading signals showing how smart money is being invested flashed red.

Known as Value at Risk, this raw but widely used measure, showed how vulnerable the long-short group on equities was to losses based on historical price movements.

As day traders competed against Wall Street, volatility doubled last week in 50 companies on the Russell 3000. At the same time, the most short-short stocks of hedge funds recovered so hard they outperformed their favorite longs to an extent rarely seen. .

With institutional clients to worry about, the pros duly cut positions across the board – while retail investors, who are free from such restrictions, passed on.

“When risk models get confused, you degrade,” said Benn Dunn, who helps these managers monitor risk as president of Alpha Theory Advisors. “What the hedge funds hold for a long time, they have to get rid of to reduce their exposure – to align their risk.”

According to Morgan Stanley’s prime brokerage, the decline in hedge fund exposure was historic last Wednesday, according to a rule of thumb for a normal distribution of statistics.

With 11 standard deviations away from the mean in the data going back to 2010, this deleveraging was the fastest since the pandemic started in March – when there was the biggest movement in a decade.

Value at Risk, a pioneer of JPMorgan Chase & Co. in the 1990s, trying to figure out how much a fund could lose in most cases: like up to $ 50 million a day, 95% of the time. While an individual is free to bear the risk of a large drawdown, hedge funds that serve institutional clients, such as pensions, are generally bound by a game plan that counteracts extreme excesses.

Last week’s challenge to the smart money was that reliable trading patterns broke. Let’s say a stock picker has a short GameStop and a long Peloton Interactive Inc. is. On most days, when both are moving in the same direction, one forms a cover for the other. But the former rose while the latter plummeted – a negative and costly co-movement.

“If you are one too short and the other long, and the correlation goes down, your risk actually goes up,” said Melissa Brown, global head of applied research at Qontigo, which provides tools for analyzing risk.

On Wednesday, an exchange-traded fund tracking hedge fund darlings (GVIP) moved seven standard deviations from the average relative to a Goldman Sachs Group Inc. basket of Russell 3000 stocks with the highest short-term interest rate. Based on 250-day data, that is outside the statistical norm.

That is of course based on a normal distribution of data, which is not well known, especially in complex modern markets. But it offers a simplified illustration of how the retail crowd caused unprecedented volatility in the institutional cohort.

There are multiple interrelated drivers behind deleveraging, and the dust has yet to settle as the retail crew once again turns to the most short-circuited names. Aside from those forced to lower positions as higher volatility drives up VaR, customer redemptions and margin calls may also have exerted pressure.

But zoomed out, the madness of the week could be another sign of a worrying trend in the financial markets: the statistically least likely moves are more likely to happen, like thicker tails.

“I’ve seen sales in all kinds of places,” Dunn said Friday. “You see things on the market that don’t make sense.”

– With the help of Lu Wang and Sam Potter